Liberating Supply-Fiscal Policy and Technological Innovation in a Multicountry Model


WP/98/95-EAWP/98/95


Summary

This paper looks at the consequences of endogenizing technological innovation
for the analysis of fiscal policies. Macroeconomic policy analyses rarely
consider the supply side of the economy in detail, concentrating instead on
cyclical factors. Yet research and development (R&D) expenditures are important
determinants of innovation and technological progress, and economic growth. By
incorporating recent empirical work on the relationship between R&D spending
and technological progress into a large macroeconomic model, this paper looks
at some of the consequences of liberating the supply side of the economy for
the analysis of fiscal policy.


The results indicate that endogenizing total factor productivity magnifies the
long-run effects of fiscal policies on the level of real GDP and stretches out
the short- to medium-run effects on economic growth. In particular, the paper
finds that incorporating R&D-induced innovation into the analysis more than
doubles the long-run welfare losses associated with higher government spending
or temporary tax cuts and reduces real growth for a very long time. To put it
somewhat differently, endogenizing R&D raises the long-run pain of adventurist
fiscal policies without providing any extra gain. Furthermore, these costs
spill over onto trading partners, because lower levels of technological
innovation in any one country hurt the rest of the world through lower demand
for their products and through reduced technological spillovers. Indeed, the
welfare costs for the rest of the world also approximately double when R&D is
included in the model.


Several lessons can be drawn from this exercise. First, supply-side
considerations can dramatically increase the costs of inappropriate policy
actions, both in the short run and in the long run. Second, these increased
costs are borne across the world, not simply in the country implementing the
policies. The international nature of these supply-side costs strengthens the
case for international cooperation and surveillance.